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Share Loans Under IRS Microscope

In a recently released Coordinated Issue Paper
(LMSB-04-1207-077), the IRS underscored how its
examinations will home in on a once-favored
strategy for monetizing stock gains while
deferring capital gains taxes. In doing so, the
Service reiterated its legal basis for why a
variable prepaid forward contract (VPFC) that
includes a share lending agreement (SLA) results
in a currently taxable sale.

Technical
Advice Memo 200604033 drew widespread
consternation when issued in January 2006 because
of the popularity of VPFCs as, it was believed, a
viable strategy to obtain cash from a highly
appreciated stock position without triggering
gain. Taxpayers had taken this position based on a
2003 revenue ruling holding that VPFCs under
certain circumstances were not sales.

COLLARING RISK, SKIRTING GAIN Generally, in a VPFC, a shareholder pledges
highly appreciated stock to an investment bank
(counterparty) in return for an options collar. In
the spread between the collar’s put and call
exercise prices, the shareholder enjoys protection
from stock price declines while still
participating in limited further appreciation. In
exchange for an upfront cash payment (generally
75% to 85% of the stock’s current fair market
value), the shareholder agrees to deliver a
variable number of shares at maturity, typically
in three to five years, or alternately to settle
with cash or other property. In most cases, the
counterparty can hedge its position by selling,
re-pledging or investing the pledged securities.
Most counterparties borrow the pledged shares and
sell them short. The counterparty may be given the
right to transfer and to vote the pledged shares.

In the earlier revenue ruling, 2003-7
(2003-1 CB 363), the Service said VPFCs per se
were not sales, actual or constructive, under
either IRC § 1001 or 1259, provided specific
requirements were satisfied. Most importantly, the
shareholder must be under no legal restraint or
requirement or under any economic compulsion to
deliver the pledged shares to the counterparty and
must have the right to deliver cash, property or
other shares. The Service also noted that
restrictions on a shareholder’s right to own
pledged common stock after the exchange date, or
an expectation that a shareholder will lack
sufficient resources to exercise the right to
deliver cash or shares other than pledged shares,
would be significant factors in determining
whether a sale has occurred.

"UNFETTERED USE" A TOUCHSTONE Then, in TAM 200604033, followed by Chief
Counsel legal advice memorandum AM-2007-004
(January 2007) and now the coordinated issue
paper, the Service said that a VPFC that includes
an SLA or other similar arrangement that allows
the counterparty to use the pledged shares results
in a current taxable sale of the underlying
shares. In TAM 200604033, the Service ruled that a
loan of shares to the counterparty allowing
“unfettered use” such as by a sale or re-pledging
effectively shifts the “benefits and burdens” of
ownership to the counterparty, resulting in a sale
under common-law principles. Because the taxpayer
discussed in the TAM had lost the right to vote
and receive dividends on the loaned shares, the
taxpayer could not retrieve the same shares from
the counterparty. The taxpayer’s argument that it
could terminate the SLA and recover voting and
dividend rights or prevent a re-borrowing of the
pledged shares and substitute identical ones was
unavailing, since the counterparty could
accelerate the transaction to hedge its risk,
forcing the taxpayer to lend the shares. Likewise,
the taxpayer’s argument that a securities loan was
eligible for nonrecognition under IRC § 1058 was
not accepted by the Service because the taxpayer
had transferred its risk of loss (and most of its
opportunity for gain).

PENALTIES PRESCRIBED The coordinated issue paper identifies
several variants of VPFC transactions that will be
deemed unfettered use by the counterparty and
provides a legal analysis of the
benefits-and-burdens test in light of the factors
that give rise to a sale for tax purposes under
Grodt & McKay Realty Inc. v.
Commissioner , 77 TC 1221 (1981). The paper
also examines factors specific to stock
transactions, including voting and dividend
rights. Perhaps most importantly, although VPFCs
are not as of this writing a listed transaction,
the paper directs examiners to consider whether
they are a reportable transaction subject to
penalties under IRC § 6707A. It also directs
examiners to consider whether the accuracy-related
penalty under section 6662 may be applicable.

Consequently, tax advisers should review
carefully with their clients the terms of any
VPFCs entered into and, if necessary, consider
grounds for a reasonable-cause exception or
disclosure of the transaction.

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